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The impact of monetary policy on consumer price index (CPI): 1985-2010


par Sylvie NIBEZA
Kigali Independent University (ULK) - Master Degree 2014
  

Disponible en mode multipage

The Impact of Monetary Policy on Consumer Price Index (CPI): (1985-2010)

Sylvie NIBEZA

Department of economics, ULK-University

Corresponding Author E-mail: sylvienibeza@gmail.com

Phone: +250 788 256 898

Declaration

I, NIBEZA Sylvie, hereby declare that the work presented in this dissertation titled «The Impact of Monetary Policy on Consumer Price Index (CPI): (1985-2010)» is my original work and it has never been submitted to any institution of learning for any award.

Signed .....................

Date: 15/11/2014

Approval

This work was done under my close supervision at Kigali Independent University supervisor.

I therefore acknowledge its authenticity and approve it as worth for the award of the Master's Degree of Science in Economics.

Signed............................................... Date 15/11/2014

Dr Moses Matundura

Dedication

To

My beloved Husband, HABAMENSHI Védaste

My Son, MUGISHA IHIRWE Willy Consolateur

My Mother, NYIRABAHIZI Agnès

My family,

All creative thinkers and Researchers.

Acknowledgements

First and foremost I thank Almighty GOD who gave me a life worth living and I thank Him for giving me the strength to accomplish this project.

My thanks go to Prof. Dr RWIGAMBA Balinda, President and Founder of Kigali Independent University (ULK) for his contribution to the development of Rwandan Higher Education and to the national development in general and good initiative deserves appreciation.

My profound gratitude is addressed to Dr. Moses Matundura, my supervisor for his immeasurable commitment, effort, positive criticisms and willingness to spare and given up his scarce time to help me acquire new skills.

I would not forget to address a word of thanks to all my lecturers in Kigali Independent University (ULK) who followed me along my academic course without their effort; I could not reach this level.

My academic education would not be possible without the support from my lovely husband Védaste HABAMENSHI. His financial and moral support was valuable in the accomplishment of my studies.

My thanks to my son Willy Consolateur MUGISHA IHIRWE, who despite their tender age endured my absence during the studies.

I also acknowledge the moral support from my mother NYIRABAHIZI Agnès, my Family and my friends.

I would like to thank all those who have, in various ways, supported me during this work, and whose their names are not written here, that they find here the expression of my deep recognition.

God bless you all.

Sylvie NIBEZA

Table of Contents

Declaration i

Approval ii

Dedication iii

Acknowledgements iv

Table of Contents v

List of Tables viii

List of Figures ix

Abbreviations and Acronyms x

Abstract xi

CHAPTER 1: INTRODUCTION TO THE STUDY 1

1.1 Background to the study 1

1.2 Problem statement 4

1.3 Purpose of the study 5

1.4 Research objectives 5

1.4.1 General objective 5

1.4.2 Specific objectives 6

1.5 Research Questions 6

1.6 Hypothesis 6

1.7 Scope of the study 6

1.8 Significance of the study 7

1.8.1 Choice of the study 7

1.8.2 Interest of study 7

1.8.2.1 Personal interest 7

1.8.2.2 Interest of the community 7

1.8.2.3 Scientific interest 8

1.9 Definitions of key terms 8

1.9.1 Money 8

1.9.2 Interest Rates 8

1.9.3 Money Supply 9

1.9.4 Exchange rate 10

1.9.5 Monetary policy 10

1.10 Organization of the dissertation 11

CHAPTER 2: LITERATURE REVIEW 12

2.1 Introduction 12

2.2 Theory of Monetary Policy 15

2.2.1 Transmission of monetary policy 17

2.2.2 Objectives of Monetary Policy 19

2.2.3 Instruments of monetary policy 23

2.2.4 Strategies of monetary policy 25

2.2.5 Taylor rule 26

2.2.6 Economic situation 28

2.2.6.1 Consumer Price Index 31

2.2.6.2 Economic effects of monetary policy 33

2.3 Monetary policy in Rwanda 35

2.3.1 Overview of monetary policy in Rwanda 35

2.3.2 Evolution of monetary policy in Rwanda 36

2.3.3 Monetary policy management 37

2.3.4 Money supply 40

2.3.5 Exchange rate 40

2.3.6 Interest rate 41

CHAPTER 3: RESEARCH METHODOLOGY 42

3.1 Introduction 42

3.2 Model Specification 42

3.3 Research Design 44

3.3.1 Quantitative and Statistics methods 44

3.4 Estimation techniques 44

3.4.1 Unit Root Test 44

3.4.2 Co-integration Test 45

3.5 Data Collection Methods and Tool 45

3.6 Sample Size 45

3.7 Statistical Test 45

3.8 Characteristics of variables 46

3.8.1 Dependent variable 46

3.8.2 Independent variables 47

3.9 Data processing 48

3.10 Limitations & Delimitations 49

CHAPTER 4: RESEARCH FINDINGS 50

4.1 Introduction 50

4.2 Strategies of monetary policy in stabilizing economy 50

4.2.1 Open market operations 50

4.2.2 Reserve requirement 51

4.2.3 Discount rate 52

4.2.4 Exchange Rate 52

4.2.5 Direct Credit Control 52

4.2.6 Moral Suasion 52

4.3 Impact of monetary policy on Consumer Price Index (CPI) 53

4.3.1 Evolution of CPI, money supply, Nominal interest rate and nominal exchange rate in

Rwanda 53

4.3.2 Econometric analysis of the impact of monetary policy on Consumer Price Index 60

4.3.2.1 Analysis of stationarity for different variables 60

4.3.2.2 Co-integration test 61

4.3.2.2.1 Estimation of an impact of monetary policy on CPI of Rwanda 62

CHAPTER FIVE: SUMMARY, CONCLUSION AND RECOMMENDATIONS 65

5.1 Introduction 65

5.2 Summary 65

5.3 General conclusion 67

5.4 Recommendations 69

References 70

List of Tables

Table 1: Consumer price index (CPI) in Rwanda 3

Table 2: Money Supply in Rwanda 55

Table 3: Nominal Interest Rate in Rwanda 56

Table 4: Nominal Exchange Rate in Rwanda 58

Table 5: Summary of Unity root Test using PP and ADF tests 60

Table 6: Results of Johansen Cointegration Test 62

List of Figures

Figure 1: Monetary targeting Framework 3

Figure 2: Consumer Price Index 33

Figure 3: Development of money supply (in billions of RWF) 40

Figure 4: Consumer Price Index (CPI) in Rwanda 54

Figure 5: Money Supply in Rwanda 56

Figure 6: Nominal Interest Rate in Rwanda 57

Figure 7: Nominal Exchange Rate in Rwanda 59

Figure 8: Response of CPI to Monetary Policy Variables 63

Abbreviations and Acronyms

 

ADF :

Augmented Dickey- Fuller

AFDB :

African Development Bank

BNR :

Banque Nationale du Rwanda

BOP :

Balance of Payment

CIP :

Crop Intensification Program

CPI :

Consumer Price Index

CUSUM :

Cumulative Sum

ECM :

Error Correction Model

EDPRS :

Economic Development and Poverty Reduction Strategy

ESAF :

Enhanced Structural Adjustment Facilities

EXCH :

Exchange Rate

GDP :

Gross Domestic Product

GOR :

Government of Rwanda

IMF :

International Monetary Fund

NIR :

Nominal Interest Rate

KRR :

Key Repo Rate

MINALOC :

Ministère de l' Administration Locale

MINECOFIN :

Ministry of Finance and Economic Planning

M2 :

Money Supply

NBR :

National Bank of Rwanda

PP :

Phillips-Perron

RWF :

Rwandan Franc (s)

ULK :

Université Lible de Kigali

Abstract

The research study on the impact of monetary policy on Consumer price index (CPI) was conducted by taking NBR as a case study. The researcher main purpose was to evaluate the use of monetary policy on economy. The specific objectives were to find out the impact of monetary policy on CPI and to describe strategies of monetary policy in stabilizing economy.

To achieve the desired objectives, the researcher consulted different documents on monetary policy and collect Secondary data on different time series where they obtained data were tested for stationarity in order to avoid regression involving non-stationary variables which can lead to misleading inferences. ADF and PP tests were used to check for stationarity. Engle- Granger two steps procedure and the Johansen Maximum Likelihood Methodology were used to see whether variables are co integrated or not. All those two tests revealed that there is no cointegration among our variables. And this has leaded us to the use of impulse response in order to estimate the impacts of monetary policy on Consumer price index.

The research found that the National Bank of Rwanda uses different tools of monetary policy in order to stabilize economy. It uses them in attempting to achieve the objectives of the monetary policy. With those tools, money supply, credit, interest rates and other monetary variables can be manipulated by the central bank of Rwanda in order to stabilize economy.

The research found that the National Bank of Rwanda uses different tools of monetary policy in order to stabilize economy.

Keywords: Money supply, Exchange rate, Nominal interest rate, monetary policy, Consumer Price Index (CPI)

CHAPTER 1: INTRODUCTION TO THE STUDY

1.1 Background to the study

Monetary policy can be defined as the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest, in order to attain a set of objectives oriented towards the growth and stability of the economy. The Central Bank is the highest authority employed by the government for formulation of monetary policy to guide the economy in a certain country. Monetary policy is defined as the regulation of the money supply and interest rates by a central bank. Monetary policy also refers to how the central bank uses interest rates and the money supply to guide economic growth by controlling inflation and stabilizing currency.

Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies.

The economic theory states that monetary policy is important policy to affect the level of output which is one of the targets of economic policy (Teigen 1978). The monetarists believe that monetary policy exerts greater impact on economic activity. The Keynesians believe that the monetary policy exerts greater influence on economic activity.

Adam Smith first delved into the subject monetary policy rules in the Wealth of Nations arguing that «a well-regulated paper-money» could have significant advantages in improving economic growth and stability compared to a pure commodity standard. By the start of the 19th century Henry Thornton and then David Ricardo were stressing the importance of rule-guided monetary policy after they saw the monetary-induced financial crises related to the Napoleonic Wars.

The choice between a monetary standard where the money supply jumped around randomly versus a simple policy rule with a smoothly growing money and credit seemed like a no brainer.

The choice was both broader and simpler than «rules versus discretion.» It was «rules versus chaotic monetary policy» whether the chaos was caused by discretion or simply exogenous shocks like gold discoveries or shortages.

A significant change in economists' search for simple monetary policy rules occurred in the 1970s, however, as a new type of macroeconomic model appeared on the scene. The new models were dynamic, stochastic, and empirically estimated. And because they incorporated both rational expectations and sticky prices, they were sophisticated enough to serve as a laboratory to examine how monetary policy rules would work in practice. These were the models that were used to find new policy rules, such as the Taylor Rule, to compare the new rules with earlier constant growth rate rules or with actual policy, and to check the rules for robustness.

Examples include the simple three equation model in Taylor (1979), the multi-equation international models in the comparative studies by Bryant, Hooper, and Mann (1993), and the econometric models in robustness analyses of Levin, Wieland, and Williams (1999).

More or less simultaneously practical experience was confirming the model simulation results as the instability of the Great Inflation of the 1970s gave way to the Great Moderation around the same time that actual monetary policy began to resemble the simple policy rules that were proposed.

From the experience of developed economies in the world which exhibit strong economic management, various countries in developing economies have undertaken economic reforms consisting essentially of a set of market-oriented economic policies intended to readjust the economy to the liberalization as well as bringing about an institutional reorganization.

Monetary policy is only one element of overall macroeconomic policy, and can only affect the production process through its impact on interest rates. Contractionary monetary policy raises longer-term real interest rates. The nominal interest rate equals the real interest rate plus the expected inflation rate. If contractionary monetary policy lowers expected inflation or leaves it unchanged, then evidence that it increases the nominal interest rate implies that it must be increasing the real interest rate also (Thorbecke and Zhang, 2008).

Hardouvelis and Barnhardt (1989), Frankel (2008) and others have shown that if monetary policy actions are expected to increase real interest rates they will lower commodity prices and if they are expected to lower inflation they will also lower commodity prices. The main cause of high interest rates is high inflation, through the expected inflation Premium. Conversely, the best prospect for low interest rates is a stable environment of low inflation.

In this context, the relatively high interest rates that may be necessary to achieve a desired disinflation represent «short-term pain for long term gain.» Central Bank, therefore, has a current focus on anti-inflation policy which will ensure steady growth in the long run (Shamshad, 2007).

In the sub-Sahara African context, reforms increased significantly in the 1990s. The broad strategy has been the emphasis placed on the policy programs supported by the International Monetary Fund (IMF) and the World Bank, including among others fiscal reforms, liberation of exchange restriction and the adoption of indirect instrument of monetary policy, market-based interest policies, and so on. (IMF, December 2000).

In such program, the monetary policy played a central role in producing macroeconomic stability. It stated that monetary and credit policies would aim at further reducing the rate of inflation, and the authorities would continue to monitor development in both reserve money and broad money closely (IMF and Rwanda 1995/2002).

The control of money supply is an important policy tool in conducting monetary policy. The success of monetary policy depends on the degree of predictability, measurability and controllability that the monetary authority has over Money supply.

Rwanda is no exception to this situation. Rwanda's economy is very small and open, heavily reliant on the export of few major products, especially coffee and tea. In addition it is also very reliant on imports for most of its consumables. The government of Rwanda's commitment to create a favorable production is deeply enshrined in its Vision 2020, where it has one of its strong pillars «Development of entrepreneurship and private sector (MINALOC.Rwanda Vision 2020 Umurenge, 2000, p4.), EDPRS in order to achieve sustainable economic development.

Monetary policy in Rwanda has had several reforms over time, from the use of direct instruments to indirect instruments to achieve macroeconomic targets within a liberalized system.

Currently, the National Bank of Rwanda (BNR) conducts monetary policy based on a monetary targeting framework with the monetary base as operating target and interest rate (the Key Repo Rate) as the policy instrument (BNR 2013, 13).

A monetary program is prepared considering the economic outlook of the country and projections based on the desired rate of monetary expansion to achieve a target rate of inflation, consistent with the projected rate of economic growth, balance of payments forecast and expected fiscal operations of the government (BNR 2013, 13).

The outcome of this study will help improve monetary policy implementation and thus strengthen macroeconomic stability in Rwanda.

1.2 Problem statement

Grinnell and Williams (1990:60) state that a problem is only a problem when something can be done to solve it. This looks appropriate to explain how different variables of the Monetary Policy work and manipulated to affect the dependent variables (CPI). This will also study the relationship among these variables by measuring the elasticity and time lag. Monetary policy influences the aggregate demand and aggregate supply affecting economy accordingly. Hyperinflation undermines saving on the one hand and prompts speculation, dollarization, capital flight through uncertainty adversely affecting the poor.

Thus, this study examines whether changes in monetary policy can account for the changes in experienced on the economy in Rwanda. This is done by adopting a model that allows simultaneous determination of the long run and short run relationship between dependent variable and independent variables in a model.

1.3 Purpose of the study

According to Lee et al., (2008) and Hacker and Hatemj, (2005) monetary policy only has a role to play in macroeconomic stabilization if the money demand function is stable. Indeed, to emphasize the stability of the demand function for money as highlighted by others (Mehra, 1993). Rwanda adopted price stability as the goal for economic stabilization (IMF, 1998: 7). The National Bank of Rwanda utilizes the M2 monetary aggregate (NBR, 2003: 30-31) as a guide variable for price stability and the monetary base (currency plus reserves) is considered the operating target (NBR, 2003: 33). From 2004 to 2008, net external reserves had increased (Kanimba, 2008:4). Therefore, the exchange rate of the Rwandan franc against major international currencies maintained a trend of a slight but continuous appreciation of the Rwandan franc against the US dollar. In 2006, Rwanda benefited from a reduction of debt due to activities of the IMF, the World Bank and the African Development Bank (AFDB, 2007). In January 2008, the National Bank of Rwanda recommended that the commercial banks increase their registered capital (Kanimba, 2008).

1.4 Research objectives

Objectives are defined as dealing with outward things or exhibiting facts uncolored by feeling or opinion. The objectives of the study are divided into two forms: main objective and specific objectives.

1.4.1 General objective

The General objective of this research is to evaluate the use of monetary policy on CPI.

1.4.2 Specific objectives

Specific objectives of this study were including:

· To analyze the impact of monetary policy on Consumer Price index.

· To find out and describe the strategies of monetary policy in stabilizing Rwandan economy.

1.5 Research Questions

By attempting to evaluate the impact of monetary policy, the questions raised are the following:

· Is there any impact of monetary policy on Consumer price index?

· What are the strategies of monetary policy in stabilizing economy in Rwanda?

1.6 Hypothesis

According to MUCHIELLI (1979:26) hypothesis are relative answers which lead work an analysis of data and they have to be tested consequently, correctly, and deeply by the Work.

From the research questions that were set the following hypothesis are formulated to guide the researcher throughout study as stated below:

Ho: monetary policy has no significant impact on CPI.

H1: monetary policy has a significant impact on CPI.

H0: monetary policy has no significant contribution to stabilize Rwandan economy.

H1: monetary policy has significant contribution to stabilize Rwandan economy.

1.7 Scope of the study

This research is limited in area (space), in time (period) and in domain.

This research is focused in NBR (Bank National du Rwanda) area in order to manage the time limits and financial constraints.

It is limited in period 1985-2010 the reason for this period is the period where some data are available and it is limited in domain of monetary policy and economy.

This study is defined in a macroeconomic framework in the sense that it deals with national income and inflation which are among major macroeconomic aggregates and the way of stabilizing them. This study concerns mainly the case of NBR.

1.8 Significance of the study

1.8.1 Choice of the study

The researcher has chosen to deal with the impact of monetary policy on consumer price index (CPI) because of the researcher want to increase her knowledge and skills in monetary policy on economy.

1.8.2 Interest of study

The interest of study is divided in personal interest, interest of the community and scientific interest

1.8.2.1 Personal interest

The interest of this research is to analyze deeply the impact of monetary policy on consumer price index (CPI).

1.8.2.2 Interest of the community

The result of this study was facilitating the implementation of suggestions and recommendations in order to improve the contributions of monetary policy on CPI.

1.8.2.3 Scientific interest

The interest of this research was facilitating to the students of Kigali Independent University (ULK) and other researchers to do the research study to fulfill their academic requirement of being awarded.

1.9 Definitions of key terms

This chapter refers to defining the key words used in the work in order to facilitate the interested reader to have the same understanding with the authors about such important concepts.

1.9.1 Money

Money is any asset that is acceptable as a medium of exchange in payment for goods and services. The functions of money are as follows:

· A medium of exchange used in payment for goods and services

· A unit of account used to relative measure prices and draw up accounts

· A standard of deferred payment : for example when using credit to purchase goods and services now but pay for them later

· A store of value: money holds its value unless there is a situation of accelerating inflation. As the general price level raises the internal value of a unit of currency decreases.

1.9.2 Interest Rates

An interest rate is the rate at which  interest is paid by a borrower (debtor) for the use of money that they borrow from a  lender (creditor). Specifically, the interest rate (I/m) is a  percentage of  principal (P) paid a certain number of times (m) per period (usually quoted per year). For example, a small company borrows capital from a bank to buy new assets for its business, and in return the lender receives interest at a predetermined interest rate for deferring the use of funds and instead lending it to the borrower.

Interest rates are normally expressed as a percentage of the principal for a period of one year. Interest-rate targets are a vital tool of  monetary policy and are taken into account when dealing with variables like  investmentinflation, and unemployment. The  Central banks of countries generally tend to reduce interest rates when they wish to increase investment and consumption in the country's economy.

The interest rates are calculated using the  simple interest formula:

Simple Interest = P ( principal) x I (annual interest rate) x N (years) ( http://www.investopedia.com/terms/i/interestrate.asp visited on 28 August, 2014).

1.9.3 Money Supply

The  quantity  of liquid assets (usually  cash) in economy  can be exchanged for  goods and services.

Increase in  money supply (relative to the  output of goods and services)  leads to  inflation, higher  employment, and  high  utilization of the  manufacturing  capacity. Its decrease leads to  deflationunemployment, and idle manufacturing capacity. It can have different meanings depending on the  degree of  liquidity chosen to  define an  asset as money. 

Measures of money supply ( called  monetary aggregates) have different  criteria in different  countries, and are categorized from the narrowest to the broadest.

( http://www.businessdictionary.com/definition/money-supply visited on 30 August, 2014).

There are different measures of money:

1. The narrowest measure of money (M1) in Rwanda includes the currency in circulation out the banking sector (CC) and checking account deposit (CD) in other words, narrow money measures cover highly liquid forms of money (Money as means of exchange).

2. The broad monetary aggregate (M2) in Rwanda adds to M1 savings deposits in Rwf and in foreign currency. It includes the less liquid forms (Money as a store of value).

1.9.4 Exchange rate

The  exchange rate is used when simply converting one currency to another (such as for the purposes of travel to another country), or for engaging in  speculation or  trading in the  foreign exchange market. There are a wide variety of  factors which influence the exchange rate, such as  interest ratesinflation, and the state of politics and the  economy in each country.

Exchange rate is also called rate of exchange or foreign exchange rate or currency exchange rate.

1.9.5 Monetary policy

Johnson defines monetary policy as «policy employing Central bank's control of the supply of money as an instrument for achieving the objectives of general economic activity». It consists of those actions undertaken by a Central bank in pursuit of macroeconomic stability.

According to A. G. Hart, a policy which influences the public stock of money substitute of public demand for such assets of both that is policy which influences public liquidity position is known as a monetary policy.

From both these definitions, it is clear that a monetary policy is related to the availability and cost of money supply in the economy in order to attain certain broad objectives.

The Central bank of a nation keeps control on the supply of money to attain the objectives of its monetary policy. Monetary policy is regulation of the money supply by the Fed in order to influence aggregate economic activity; the Fed's role in supplying money to the economy.

Economic regulation is a Government's measure aimed to controlled price, output, market entry and exit, and product quality in situations where monopoly is inevitable or desirable.

1.10 Organization of the dissertation

The study is divided into five chapters: It begins with an introduction presenting the back ground of the study, significance of the study, the scope of the study, problem statement as well as the hypothesis and the objectives and then the organization of the study is constructed as follow:

The first chapter is related to the study includes the problem statement, the objectives of the study, the research motivation and the structure of the study is outlined in this chapter.

The second chapter is related to the literature review which is attempted to define and explain some key concepts, Books and journal articles have been consulted to find out how different authors explain theories and/or provide evidences related to the topic the impact of monetary policy on consumer price index (CPI).

The third chapter discusses the method to analyze the data and information collected estimation used in chapters 4.

The fourth chapter was analyzed the findings on data collected on monetary policy and see how this chapter is verified.

The fifth chapters are related to the summary, conclusion and policy recommendations of the study.

CHAPTER 2: LITERATURE REVIEW

Introduction

This chapter refers to defining the key words used in the work in order to facilitate the interested reader to have the same understanding with the authors about such important concepts.

It is also aimed at analyzing and putting in place all theories made by different authors, scholars and researchers and it facilitate to understand the different relationship between terms or concepts of the topic in order to understand deeply this topic which is the monetary policy on CPI.

According to Monetary Theory, Monetary Policy manipulates the money supply and rate of interest in such a way to achieve the goals of the manifestation of the ruling party (Shoaib k, 2010).

Monetary Policy provides a logical relationship between its variables stipulated to affects the outcomes regarding the Central Bank applies these tools to regulate the money creation, targeting the rate of interest to manage the pace of monetary circulation. The objective is to stabilize internal and external value of the currency (Wikipedia, Monetary policy September, 2014).

In present times wide range monetary decisions are required such as short term and long term interest rates; velocity of money; exchange rates; bonds and equities. They will also have to look into the government and private expenditure; savings; inflows of capital and other financial derivatives (Wikipedia, Monetary policy September, 2014).

Many scholars who have investigated on the effect of monetary policy have come up with varieties of remedial steps.

Tailor (1963) studied the interest rate effect of monetary transmission mechanism and

Observed that contractionary monetary policy leads to a rise in domestic real interest rates, raises cost of capital, thereby causing a fall in investment spending and a decline in output.

Ozme (1998) adopted a simplified Ordinary Least Square techniques in his analysis on monetary policy and macroeconomic stabilization in Nigeria and found out that interest rate has an insignificant influence on price stability.

Killick and Mwega (1990:3) recapitulated traditional monetary policy goals to include price stability, promoting growth, achieving full employment, smoothing the business cycle, preventing financial crises, and stabilizing long-term interest rates and the real exchange rate.

Genev (2002) studied the effects of monetary shocks in 10 Central and Eastern European (CEE) countries and found some indication that changes in the Exchange rate affects output but no evidence that suggests that changes in interest rate affect output.

Balogun (2007) used simultaneous equation model in testing the hypothesis of effectiveness of monetary policy in Nigeria, and found out that rather than promote growth, domestic monetary policy was a source of stagnation and persistent inflation.

Okwo and Nwoha (2010) examined the effect of monetary policy outcomes on macroeconomic stability in Nigeria using a simplified Ordinary least square technique stated in multiple forms. They found out that there exists an insignificant relationship between monetary policy, gross domestic product, credit to private sector and inflation in Nigeria.

Omoke and Ugwuanyi (2010) in their long - run study of money, prices and output in

Nigeria found out that there exists no co-integrating vector but however proved that money supply granger causes both output and inflation. Thus, suggest that monetary stability can contribute towards price stability since inflation in Nigeria is a monetary phenomenon.

Nwosa (2011) in his appraisal of monetary policy development in Nigeria, examined the effect of monetary policy on macroeconomic variables using an Ordinary Least Square technique after conducting the unit root, co -integration tests revealed that monetary policy has a significant effect on exchange rate and an insignificant influence on price stability.

Government policies, including monetary policy, affect the growth of domestic output to the extent that they affect the quantity and productivity of capital and labor. Monetary policy is only one element of overall macroeconomic policy, and can only affect the production process through its impact on interest rates.

There are two main channels of monetary policy. One is through the effect that interest rate changes have on the exchange rate of a currency, and the other is through the effect that interest rate changes have on demand. Therefore monetary policy has an impact on economic activity and growth through the workings of foreign and domestic markets for goods and services (Boweni, 2000)

The instrument of monetary policy ought to be the short term interest rate, that policy should be focused on the control of inflation, and that inflation can be reduced by increasing short term interest rates (Alvarez, 2001).

Kuttner and Mosser (2002) indicated that monetary policy affects the economy through several

Transmission mechanisms such as the interest rate channel, the exchange rate channel, Tobin's q theory, the wealth effect, the monetarist channel, and the credit channels including the bank lending channel and the balance-sheet channel. But mainly monetary policy plays its role in controlling inflation through money supply and interest rate. Money Supply (M2) would affect real GDP positively because an increase in real quantity of money causes the nominal interest rate to decline and real output to rise (Hsing, 2005).

Friedman (1963) emphasizes money supply as the key factor affecting the wellbeing of the economy. Thus, in order to promote steady growth rate, the money supply should grow at a fixed rate, instead of being regulated and altered by the monetary authority.

After the Great Depression, JM Keynes who advocates for demand management policies, for the first time recognized the direct effect of money supply on the economic health of a nation.

He also argues for intervention of the Central Bank to operate monetary policy to stabilize the economy (Shoaibk, 2010).

The concepts defined in this study are: Consumer Price Index, Nominal Interest Rate, Money Supply and Exchange rate.

2.1 Theory of Monetary Policy

Monetary policy is the process by which the government, Central bank or monetary authority of a country controls: (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest to attain a set of objectives oriented towards the growth and stability of the economy.

Monetary theory provides insight into how to craft optimal monetary policy.

Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies.

Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a Central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (to achieve policy goals). If policymakers believe that private agents anticipate low inflation, they have an incentive to adopt an expansionist monetary policy (where the  marginal benefit of increasing economic output outweighs the   marginal cost of inflation); however, assuming private agents have  rational expectations, they know that policymakers have this incentive.

Hence, private agents know that if they anticipate low inflation, an expansionist policy will be adopted that causes a rise in inflation.

Consequently, (unless policymakers can make their announcement of low inflation credible), private agents expect high inflation.

This anticipation is fulfilled through adaptive expectation (wage-setting behavior); so, there is higher inflation (without the benefit of increased output). Hence, unless credible announcements can be made, expansionary monetary policy will fail.

While a Central bank might have a favorable reputation due to good performance in conducting monetary policy, the same Central bank might not have chosen any particular form of commitment (such as targeting a certain range for inflation).

Reputation plays a crucial role in determining how much markets would believe the announcement of a particular commitment to a policy goal but both concepts should not be assimilated. Also, note that under rational expectations, it is not necessary for the policymaker to have established its reputation through past policy actions; as an example, the reputation of the head of the Central bank might be derived entirely from his or her ideology, professional background, public statements.

In fact it has been argued that to prevent some pathology related to the  time inconsistency of monetary policy implementation (in particular excessive inflation), the head of a Central bank should have a larger distaste for inflation than the rest of the economy on average. Hence the reputation of a particular Central bank is not necessary tied to past performance, but rather to particular institutional arrangements that the markets can use to form inflation expectations.

Despite the frequent discussion of credibility as it relates to monetary policy, the exact meaning of credibility is rarely defined. Such lack of clarity can serve to lead policy away from what is believed to be the most beneficial. For example, capability to serve the public interest is one definition of credibility often associated with Central banks.

The reliability which a Central bank keeps its promises is also a common definition. While everyone most likely agrees a Central bank should not lie to the public, wide disagreement exists on how a Central bank can best serve the public interest.

Therefore, lack of definition can lead people to believe their supporting one particular policy of credibility when they are really supporting another ( B.M. Friedman, 2001).

Before proceeding to review what other researchers have found about relationship of CPI and Money supply, interest rate, and Inflation, we first attempt to explain the importance of monetary policy in light of available literature.

Government policies, including monetary policy, affect the growth of domestic output to the extent that they affect the quantity and productivity of capital and labor. Monetary policy is only one element of overall macroeconomic policy, and can only affect the production process through its impact on interest rates.

There are two main channels of monetary policy. One is through the effect that interest rate changes have on the exchange rate of a currency, and the other is through the effect that interest rate changes have on demand. Therefore monetary policy has an impact on economic activity and growth through the workings of foreign and domestic markets for goods and services (Boweni, 2000)

Kuttner and Mosser (2002) indicated that monetary policy affects the economy through several transmission mechanisms such as the interest rate channel, the exchange rate channel but mainly monetary policy plays its role in controlling inflation through money supply and interest rate. Money Supply (M2) would affect real GDP positively because an increase in real quantity of money causes the nominal interest rate to decline and real output to rise (Hsing, 2005).

The National Bank of Rwanda establishes and enforces banking rules that affect monetary policy and the overall level of the competition between different banks. It determines which non-banking activities, such as brokerage services, leasing and insurance, are appropriate for banks and which should be prohibited.

The National Bank of Rwanda is also responsible for supervising the central insurance funds that protects the deposits of member institution (O.C. Ferrell et al, 2006).

2.1.1 Transmission of monetary policy

The monetary policy transmission mechanism describes the channels through which changes in monetary policy affect the objective target. It describes how private sector agents respond to the policy actions of the monetary authorities. The channels through which monetary policy are transmitted are varied and complex depending on the financial structure, expectations, openness of the economy and production functions. In the long run the price level is determined solely by the actions of the monetary authorities.

This stems from the fact that the central bank alone creates the ultimate means of payments, base money, on which a monetary economy depends.

By altering the terms at which this means of payment is provided, the authorities are able to determine the nominal value of transactions in the economy and hence the price level in the long run.

To a large extent the debate on the mechanism is centered on the precise temporal impact of monetary shocks on the economy and the means by which such shocks are propagated. The intellectual divide on this issue involves the classical /monetarist school (Friedman, Cagan, Meltzer, MaCallum, Lucas et al) and the Keynesians/Neo-Keynesians such as Grossman, Mankiw and Romer among others.

For the case of Rwanda, the transmission of monetary policy can be schematized as follow:

Figure 1: Monetary targeting Framework

Source: BNR, Economic Review no3

Based on this figure, the NBR sets base money as an operating target with the intention of changing the intermediate target of any monetary aggregate (money stock in the economy). Indeed monetary aggregate targeting is part of the strategy by which the National Bank of Rwanda chooses the money stock as the nominal anchor for achieving price stability as a final objective. To attain this final objective, the following two requirements are necessary:

(i) A stable demand functions for money;

(ii) A long-run relationship between the money stock and the price level (Hansen and Kim, 1995:286).

2.1.2 Objectives of Monetary Policy

Broadly speaking, the objective of monetary policy is to influence the performance of the economy as reflected in factors such as inflation, economic output and employment. It works by affecting demand across the economy in terms of people and firms willingness to spend on goods and services (Federal Reserve Bank of San Francisco, 2004). The objectives of a monetary policy are similar, planning aims at growth, stability and social justice.

After the Keynesian revolution in economics, many people accepted significance of monetary policy in attaining following objectives ( http://www.yourarticlelibrary.com/policies/monetary-policy-meaning-objectives-and-instruments-of-monetary-policy/11134/ visited on 17 September 2014):

· Rapid economic growth

· Price stability

· Exchange rate stability

· Balance of Payment Equilibrium (BOP)

· Full employment

· Equal income Distribution

These are the general objectives which every Central bank of a nation tries to attain by employing certain tools (instruments) of a monetary policy.

In Rwanda the Central bank has always aimed to control the expansion of bank credit and money supply, with special attention to the season needs of a credit.

The objectives of monetary policy in detail

( http://www.yourarticlelibrary.com/policies/monetary-policy-meaning-objectives-and-instruments-of-monetary-policy/11134/ visited on 17 September 2014):

1. Rapid economic growth

It's the most important objective of a monetary policy. The monetary policy can influence economic growth by controlling real interest rate and its resultant impact on investment.

If the Central bank opts for a cheap or easy credit policy by reducing interest rates, the investment level in the economy can be encouraged. This increased investment can speed up economic growth is possible if the monetary policy succeeds in maintaining income and price stability.

2. Price stability

All the economics suffer from inflation and deflation. It can be also called as price instability. Both inflation and deflation are harmful to the economy. Thus, the monetary policy having an objective of price stability tries to keep the value of money stable. It helps in reducing the income and wealth inequalities. When the economy suffers from recession the monetary policy should be an easy money policy but when there is inflationary situation there should be a dear money policy.

3. Exchange rate stability

Exchange rate is the price of a home currency expressed in terms of any foreign currency. If this exchange rate is very volatile leading to frequent ups and downs in the exchange rate, the international community might lose confidence in our economy. The monetary policy aims at maintaining the relative stability in the exchange rate. The Central bank by altering the foreign exchange is tries to maintain the exchange rate stability.

4. Balance of Payment Equilibrium (BOP)

Many developing countries like Rwanda suffer from the disequilibrium in the BOP. The Central bank through its monetary policy tries to maintain equilibrium in the balance of payments. The BOP has two aspects: the BOP Surplus and the BOP Deficit. The former reflects an excess money supply in the domestic economy, while the later stands for stringency of money. If the monetary policy succeeds in maintaining monetary equilibrium, then the BOP equilibrium can be achieved.

5. Full employment

The concept of full employment was much discussed after Keynes's publication of the «General Theory» in 1936. It refers to absence of involuntary unemployment. In simple words «full employment» stands for a situation in which everybody who wants jobs gets jobs. However it does not mean that there is zero unemployment. In that senses the full employment is never full. Monetary policy can be used for achieving full employment. If the monetary policy is expansionary the credit supply can be encouraged. It could help in creating more jobs in different sector of the economy.

6. Neutrality of money

Economists such as Wicksted, Robertson and others have always considered money as passive factor. According to them, money should play only a role of medium of exchange and not more than that. Therefore, the monetary policy should regulate the supply of money. The change in money supply creates monetary disequilibrium. Thus monetary policy has to regulate the supply of money and neutralize the effect of money expansion. However this objective of a monetary policy is always criticized on the ground that if money supply is kept constant then it would be difficult to attain price stability.

7. Equal income distribution

Many economists used equal income distribution to justify the role of fiscal policy in order to maintain economic equality. However in recent years, economists have given the opinion that the monetary policy can help and play a supplementary role in attainting economic equality. Monetary policy can make special provisions for the neglect supply such as agriculture, small- scale industries, village industries, etc. and provide them with cheaper credit for long term.

This can prove fruitful for these sectors to come up. Thus in recent period, monetary policy can help in reducing economic inequalities among different sections of society.

The goal of monetary policy is set out in the National Bank of Rwanda (BNR) Law which requires the BNR to conduct monetary policy in a way to deliver price stability and in low inflation environment. Law no 55/2007 of 30/11/2007 governing the Central bank of Rwanda assigns to the BNR responsibility of formulating and implementing monetary policy.

According to article 5 of the same law, the main missions of the National Bank of Rwanda shall be:

· To ensure and maintain price stability

· To enhance and maintain a stable and competitive financial system without any exclusion

· To support Government's general economic policies, without prejudice to the two missions referred to in Paragraphs 1° and 2° above.

These objectives allow the National Bank of Rwanda to focus on price stability while taking into account of the implications of monetary policy for the whole economic activity and, therefore, price stability is a crucial precondition for sustained economic growth. The National Bank of Rwanda agrees on the importance of low inflation and low inflation expectations. NBR mission's assists businesses in making sound investment decisions, underpin the creation of jobs, protect the savings of Rwandans and preserve the value of the national currency.

In pursuing the goal of medium-term to long term price stability, the National Bank of Rwanda agrees with the Government on the objective of keeping consumer price inflation low and stable. This formulation allows short-run variation in inflation while preserving a clearly identifiable performance benchmark over time.

To achieve the price stability objective, the BNR currently operates in a flexible monetary targeting framework with the monetary base as operating target, broad money aggregate as an intermediate target and inflation as the ultimate goal. The BNR monitors movements in monetary base on daily basis in line with the targets as set in the annual monetary program.

In that exercise, the BNR uses several policy instruments mainly open market operations, discount rate and reserve requirement.

The key repo rate (policy rate) set by the monetary policy committee is used to signal the stance of monetary policy.

2.1.3 Instruments of monetary policy

The instruments or tools of monetary policy are of two types Qualitative and Quantitative in nature.

Qualitative control includes change in margin requirements, regulation of consumer credit, moral persuasion, publicity, direct action.

Quantitative control includes open market operations, the reserve ratio, the discount rate, Foreign Exchange Interventions.

Monetary policy guides the Central bank's supply of money in order to achieve the objectives of price stability (or low inflation rate), full employment, and growth in aggregate income.

The instruments of monetary policy used by the Central bank depend on the level of development of the economy, especially its financial sector (Federal Reserve System and Monetary Policy, 1979).

The commonly used instruments are:

1. Reserve Requirement

The monetary authority exerts regulatory control over banks. Monetary policy can be implemented by changing the proportion of total assets that banks must hold in reserve with the central bank. Banks only maintain a small portion of their assets as cash available for immediate withdrawal; the rest is invested in illiquid assets like mortgages and loans.

By changing the proportion of total assets to be held as liquid cash, the Federal Reserve changes the availability of loan able funds. This acts as a change in the money supply. Central banks typically do not change the reserve requirements often because it creates very volatile changes in the money supply due to the lending multiplier.

2. Open Market Operations

The Central bank buys or sells ((on behalf of the Fiscal Authorities (the Treasury)) securities to the banking and non-banking public (that is in the open market).

One such security is Treasury Bills. When the Central bank sells securities, it reduces the supply of reserves and when it buys (back) securities-by redeeming them-it increases the supply of reserves to the Deposit Money Banks, thus affecting the supply of money.

3. Lending by the Central bank

The Central bank sometimes provide credit to Deposit Money Banks, thus affecting the level of reserves and hence the monetary base.

4. Interest Rate

The Central bank lends to financially sound Deposit Money Banks at a most favorable rate of interest, called the minimum rediscount rate (MRR). The MRR sets the floor for the interest rate regime in the money market (the nominal anchor rate) and thereby affects the supply of credit, the supply of savings (which affects the supply of reserves and monetary aggregate) and the supply of investment (which affects full employment and GDP).

5. Direct Credit Control

The Central bank can direct Deposit Money Banks on the maximum percentage or amount of loans (credit ceilings) to different economic sectors or activities, interest rate caps, liquid asset ratio and issue credit guarantee to preferred loans. In this way the available savings is allocated and investment directed in particular directions.

6. Moral Suasion

The Central bank issues licenses or operating permit to Deposit Money Banks and also regulates the operation of the banking system. It can, from this advantage, persuade banks to follow certain paths such as credit restraint or expansion, increased savings mobilization and promotion of exports through financial support, which otherwise they may not do, on the basis of their risk/return assessment.

7. Prudential Guidelines

The Central bank may in writing require the Deposit Money Banks to exercise particular care in their operations in order that specified outcomes are realized.

Key elements of prudential guidelines remove some discretion from bank management and replace it with rules in decision making.

8. Exchange Rate

The balance of payments can be in deficit or in surplus and each of these affect the monetary base, and hence the money supply in one direction or the other. By selling or buying foreign exchange, the Central bank ensures that the exchange rate is at levels that do not affect domestic money supply in undesired direction, through the balance of payments and the real.

2.1.4 Strategies of monetary policy

Having identified the instruments available for active monetary policy implementation, it is important to understand the current conduct of monetary policy needs to be operated within a well-defined to independent Central bank. This means simply to provide the authorities of Central banks with the power to determine quantities and interest rates on its own transactions without interference from government institutions (Lybeck, 1998 quoted in Worrel, 2000).

Similarly, Blinder (1998) shows that Central bank independence means two things: Firstly, that the Central bank has the freedom to decide how to pursue its goals, and secondly, that its decisions are very difficult for other branches of government to reverse.

This implies that an independent Central bank needs to be free of the political pressures that influence other government institutions. This is particularly important when a Central bank needs to target inflation, exchange rates or the monetary base for example.

On this basis, an important point to analyze could be the way Central banks process before following a given strategy.

Monetary policy will aim at keeping the annual inflation rate below 5 percent. The monetary authorities will pursue a reserve money target, while closely monitoring developments in bank liquidity and broad money.

The BNR will control monetary aggregates and influence interest rates through indirect instruments: the Treasury bill auctions (commenced in late 1998) and money market operations on its own account.

The Government intends to progressively replace the outstanding stock of consolidated debt held by commercial banks by negotiable treasury bills in the course of 1999-2000, so as to contribute to the development of a secondary market for government paper. Coordination between the Ministry of Finance and the BNR will be strengthened to ensure the consistency of the program's fiscal and monetary objectives.

2.1.5 Taylor rule

The Taylor rule is also known as a simple interest rate rule. That is, simply speaking, it is the current practice where Central bankers could formulate policy in terms of interest rates. This rule was originally proposed by the economist John Taylor following to the need of American Central bank to set the interest rates to achieve stable price while avoiding large fluctuations in output and employment (Mankiw, 2000).

Considering the monetary transmission mechanism as the process through which monetary policy decisions are transmitted into changes in real GDP and inflation, Taylor (1995) argued that most Central banks today are taking actions in the monetary market to guide the short-term interest rate in a particular way. In other words, rather than changing the money supply by a given amount and then letting the short-term interest rate take a course implied by money demand, the Central banks adjust the supply of high-powered money in order to give certain desired movements to the fund rate. The aim knows how much the Central bank should adjust the short-term interest rate in response to various factors in the economy including real GDP and inflation.

Taylor proposed a simple interest rule in which the funds rate reacts to two variables: the deviation of inflation from a target rate of inflation, and the percentage deviation for real GDP from potential GDP.

Specifically, the Taylor rule can be written as follows:

In this equation,

  Is the target short-term  nominal interest rate 

· is the rate of  inflation as measured by the  GDP deflator

·   is the desired rate of inflation,

·   is the assumed equilibrium real interest rate,

·   is the logarithm of real  GDP

·  is the logarithm of  potential output, as determined by a linear trend.

In this equation,

Both  and  should be positive (as a rough rule of thumb, Taylor's 1993 paper proposed setting

That is, the rule "recommends" a relatively high interest rate (a "tight" monetary policy) when inflation is above its target or when output is above its  full-employment level, in order to reduce inflationary pressure.

It recommends a relatively low interest rate ("easy" monetary policy) in the opposite situation, to stimulate output. Sometimes monetary policy goals may conflict, as in the case of stagflation, when inflation is above its target while output is below full employment. In such a situation, a Taylor rule specifies the relative weights given to reducing inflation versus increasing output

The Taylor principle states that the Central bank's policy interest rate should be increased more than one for one with increases in the inflation rate.

( http://en.wikipedia.org/wiki/Taylor_rule visited on 2 September, 2014)

The Taylor principle ensures that an increase in the inflation rate produces a policy reaction that increases the real rate of interest. The rise in the real interest reduces private spending, slows the economy down and brings inflation back to the Central bank's inflation target.

Conversely, if inflation falls below the Central bank's target, the Taylor principle calls for a more than one for one cut in the Central bank's policy interest rate. This reduces the real rate of interest, stimulates private spending, and pushes inflation back to its target level (Walsh, 2001).

Over several years there has been an emerging consensus among economist authors that the Taylor rule appears to be a good description of the interest rate policies of many Central banks. Thus, Taylor's rule is the most popular approach to the empirical analysis of reaction functions (Sanchez-Fung, 2000).

Mankiw (2000) shows that Taylor's rule for monetary policy is not only simple and reasonable, but also resembles the American Central bank behavior in recent years fairly accurately.

In the light of the different policy rules mentioned above, it is worth noting that studies on monetary policy rules show that it is possible to use very simple rules to achieve better economic performance. However, generally speaking, the question of determining the best rule needs first of all a better understanding of the transmission mechanism of monetary policy through the economic system.

 The exchange rate will continue to be market determined, with the BNR's intervention in the exchange market confined to meeting the net foreign assets target and smoothing short-term exchange rate fluctuations, while not resisting underlying trends.

To improve the functioning of the exchange market, the BNR will continue to communicate to economic agents the cost advantages of bank settlements instead of cash transactions (currently causing a premium for dollar bills), and develop a forward market, for which the regulatory framework was established in May 1999.

2.1.6 Economic situation

Rwanda's economy is agrarian. Agriculture employs almost 80 percent of the population, accounting for more than 40 percent of gross domestic product (GDP) and more than 70 percent of exports. Subsistence food production is the dominant activity in the agriculture sector. Production of coffee and tea for export is still modest.

The service sector contributes approximately 39 percent of GDP and employs roughly 6.5 percent of the working population. The percentage of Rwandans living in poverty has decreased from 60.4 percent in 2000-2001 to 56.9 percent in 2005-2006.

(National Institute of Statistics Rwanda, `Preliminary Poverty Update Report, Integrated Living Conditions Survey 2005/06' December 2006.)

Rwanda's economic growth was rapid in the years following the genocide, largely due to determined economic policy, the `catch-up' effect (due to starting from a very low baseline in 1994) and relatively high aid flows. Economic growth has been more modest in recent years. For 2007, the GoR forecast for GDP growth is 6.0 percent

Rwanda embarked on a continuous, aggressive, ambitious agenda of political, financial and economic reforms to establish an attractive environment for both domestic and foreign investments. Rwanda has continuously improved its policy and institutional reforms towards poverty reduction.

It is evident that Rwanda is an example of success stories in post-conflict reconstruction (Bigsten and Isaksson, 2008). Rwanda has made progress in fighting corruption and promoting gender equality, as well as creating a soft business environment. It is one of the most improved countries in the world in the annual Doing Business Index, thus attracting both private and foreign direct investments.

Rwanda's economy has demonstrated a strong recovery from the global recession. Real GDP growth edged up to 7.5% in 2010 from 4.1% in 2009 due to expansion in government spending, robust growth in services (primarily telecom and financial services) and recovery in tourism. The large fiscal stimulus and expansionary monetary policy implemented in 2010 bolstered the recovery. Key growth drivers in the short and medium term include expansion in services sector, increased productivity in the agriculture sector, and increased public and private investment (AfDB, Research Department using data from WEF, 2010).

The services sector accounts for the largest share of GDP at 47% and its share has continued to grow during the period 1995-2010 while shares for industry and agriculture have been declining. Growth in services has been fuelled by expansion in trade, transport, telecommunications, finance and insurance (Human Development Report, 1999).

GoR's responses include a Crop Intensification Program (CIP) implemented since 2008 and focusing on several priorities including land use consolidation; Fertilizer and seed distribution; and post-harvest activities and marketing and a Strategic Plan for the Transformation of Agriculture, Phase II (2009-12).

As a result, food production has increased and this has shielded Rwanda from the on-going food crisis in the Horn of Africa.

According to Macroeconomic framework and strategy for the period 1999-2002, the main elements of the medium-term macroeconomic program are:

(i) To achieve annual average real GDP growth rate of 5-6 percent a year;

(ii) To keep inflation at below 5 percent a year;

(iii) To maintain the external current account deficit (excluding official transfers) at about 17 percent of GDP and the level of gross official reserves at a level of at least four months of imports, whereas the high growth rate in real GDP in 1995-98 was achieved by bringing existing capacity back into use, hence forth, sustained growth at the targeted rate would require a significant increase in investment, from 15½ percent of GDP in 1998-99 to 19½ percent in 2001-2002 (African Economic Outlook,2010).

With government investment projected at about 9 percent of GDP, an increase in private investment from 8½ percent of GDP in 1998-99 to more than 10 percent in 2001-2002 would be needed, as well as similar increase in private savings. Increases in investment and savings levels will depend on continued progress in restoring confidence in the economy, which, in turn, depends on the progress in national reconciliation, domestic and regional security, and structural reforms. Significant foreign aid, including assistance to reduce the external debt burden, will remain essential to enable Rwanda to achieve high and sustainable growth.

2.1.6.1 Consumer Price Index

International Labour Office (ILO) defined consumer prices index (CPI) as index numbers that measure changes in the prices of goods and services purchased or otherwise acquired by households, which households use directly, or indirectly, to satisfy their own needs and wants.

According to the National Institute of Statistic of Rwanda, The CPI is a measure of the average change over time in the prices of consumer items goods and services that people buy for day-to-day living. The CPI is a complex construct that combines economic theory with sampling and other statistical techniques and uses data collected each month to produce a timely measure of average price change for the consumption sector of the Rwandan economy (NISR: March 2010)

The CPI can be intended to measure either the rate of price inflation as perceived by households, or changes in their cost of living (that is, change in the amounts that the households need to spend in order to maintain their standard of living).

In practice, most CPI are calculated as weighted averages of the percentage price changes for specified set, or «basket», of consumer products, the weights reflecting their relative importance in household consumption in some period. Much depend on how appropriate and timely the weights are. (ILO 2004:4).

However there is some criticism in calculation of this CPI whereby the prices collected were not a fair sample of the prices that actually existed for goods of equal quality.

According to the Morgan (1947:29) CPI neglect to consider the following:

1. Underreporting of prices by stores and large rise in prices of important goods not included in the index.

2. Disappearance of low grades of goods and deterioration in the quality of goods priced.

3. Large retail-price increase in smaller cities not covered by the index

According to the National Institute of Statistics of Rwanda (CPI October 2009), The CPI is a Modified Laspeyres index that covers household consumption as it is used by national accounts. The reference population for the CPI consists of all households living in urban areas in Rwanda.

The household basket includes 1,136 products observed in many places spread all over the administrative centers of all provinces in Rwanda. All kinds of places of observation are selected: shops, markets, services, etc. More than 29,200 prices are collected every month by enumerators of the National Institute of Statistics of Rwanda and of the National Bank of Rwanda.

The weights used for the new index (CPI of the Base year of February 2009) are the result of the Household Living Conditions Survey (EICV II) conducted in 2005-2006 with a sample of 6,900 households.

The basket used in measuring CPI by NISR is composed by the following division of commodities:

1. Food and non-alcoholic beverages (Bread and Cereals, Meat, Fish, Vegetables, Non-alcoholic beverages)

2. Alcoholic beverages and tobacco

3. Clothing and footwear

4. Housing, water, electricity, gas and other fuels

5. Furnishing, household equipment and routine household maintenance

6. Health

7. Transport

8. Communication

9. Recreation and culture

10. Education

11. Restaurants and hotels

12. Miscellaneous goods and services.

Rwanda has implemented an expansionary monetary policy stance aimed at reversing the domestic liquidity crisis that started in 2008 and to accelerate the rebound in growth. However, structural rigidities and low financial sector depth impeded the fiscal stimulus effects. Successful implementation of CIP contributed to a reduction in inflation from 2011 10.3% in 2009 to 2.3% in 2010 However, since Rwanda remains a net food importer and given the large import share of energy products (19.5% in 2010), inflation is projected to edge upwards to 3.9% in 2011 due to the rising global food and fuel prices.

CPI from 2003 up to 2010 can be schematized by the following figure:

Figure 2: Consumer Price Index

Source: AfDB Statistics Department, African Economic Outlook April 2010

2.1.6.2 Economic effects of monetary policy

The Central bank tries to maintain price stability through controlling the level of money supply. Thus, monetary policy plays a stabilizing role in influencing economic growth through a number of channels. However, the scope of such a role may be limited by the concurrent pursuit of other primary objectives of monetary policy, the nature of monetary policy transmission mechanism, and by other factors, including the uncertainty facing policy makers and the stance of economic policies.

In addition, the concurrent target of intermediate goals may have implications on the attainment of the ultimate objective of achieving sustainable growth. The contribution of monetary policy maker to sustainable growth is the maintenance of price stability.

Since sustained increase in price levels is adjudged substantially to be a monetary phenomenon, monetary policy uses its tools to effectively check money supply with a view to maintaining price stability in the medium to long term.

Theory and empirical evidence in the literature suggest that sustainable long term growth is associated with lower price levels. In other words, high inflation is damaging to long-run economic performance and welfare.

Monetary policy has far reaching impact on financing conditions in the economy, not just the costs, but also the availability of credit, banks' willingness to assume specific risks, etc.

It also influences expectations about the future direction of economic activity and inflation, thus affecting the prices of goods, asset prices, exchange rates as well as consumption and investment.

A monetary policy decision that cuts interest rate, for example, lowers the cost of borrowing, resulting in higher investment activity and the purchase of consumer durables.

The expectation that economic activity will strengthen may also prompt banks to ease lending policy, which in turn enables business and households to boost spending.

In a low interest-rate regime, stocks become more attractive to buy, raising households' financial assets. This may also contribute to higher consumer spending, and makes companies' investment projects more attractive.

Low interest rates also tend to cause currency to depreciate because the demand for domestic goods rises when imported goods become more expensive. The combination of these factors raises output and employment as well as investment and consumer spending.

2.2 Monetary policy in Rwanda

2.2.1 Overview of monetary policy in Rwanda

The National Bank of Rwanda (NBR) was instituted under the terms of the law in April 1964

As a national, publicly owned, establishment equipped with a civil personality and financial autonomy. The NBR has the following general missions:

· To formulate and implement monetary policy to protect the value of the currency and to ensure stability of the Rwandan Franc. For this purpose, it controls the currency and manages operations in the money market, regulates banking structures and monitors the foreign exchange market (NBR, 1999);

· Has the exclusive privilege of providing currency or legal tender in Rwanda;

· Manages the State's portfolio at its disposal and ensures the execution of financial transactions on behalf of the State, that is, the NBR is the financial agent of the State for any credit, banking, and cash transactions.

Since its establishment, the NBR had to ensure that monetary and credit conditions were in accordance with the overall economic policies decided by the Rwandan government at least until 1990, when the implementation of the IMF's Enhanced Structural Adjustment Facilities (ESAF) in Rwanda began. Later, a law was passed in 1997, to give the NBR greater autonomy. Further, a new banking law was adopted and promulgated in June 1999, giving the necessary power to the board of the NBR to determine monetary policy. This law has also strengthened the NBR's role in supervising financial institutions and enforcing rules of sound banking practice that are in conformity with international standards.

The ESAF, which began in 1990, gave monetary policy another way to influence financial markets. With the disappearance of the credit rationing, rediscounting and setting of interest rates, a new era emerged, as regards monetary management, characterized in particular, by the introduction of the money market as a main source of funds and it became the arena for the determination of interest rates. In other words, interest rates were now determined by the market.

A flexible exchange rate regime was introduced in Rwanda in March 1995 with the creation of foreign exchange markets, which meant exchange rates, were now partially determined by the forces of demand and supply. The NBR does however ensure a smooth path of exchange rates by occasional intervention.

2.2.2 Evolution of monetary policy in Rwanda

The NBR was required to organize all monetary matters in Rwanda. Thus it was required to support the realization of the social and economic objectives planned by the government. Indeed, the National Bank of Rwanda was regarded as being that entity able to guide the social and economic development undertaken in the country.

In addition, it was also required to implement monetary policy in order to achieve particular macroeconomic objectives. In this context, and in order to make the banking system comply with the aims of the government, the National Bank of Rwanda decided to control directly, the banking system.

The central bank then, had to proceed, for this reason, to control the credit given by the banks to their customers. In addition, they had to determine the allocation of credit to the various economic sectors according to a scale of priority based primarily, on the strategic choices required by the government. Moreover, the NBR determined the level of interest rates in the economy. This monetary policy remained unchanged until the end of the 1980's.

It is only at the beginning of the next decade, that the monetary policy started to take a new orientation, with the implementation in November 1990, of the first Structural Adjustment Program. For two and a half decades the NBR intervened in the macro economy using monetary policy. The NBR intervened by controlling both the demand and the supply of credit.

2.2.3 Monetary policy management

The National Bank of Rwanda implements the monetary policy through three tools:

· Open market operations

· The discount rate

· The reserve requirement

During last decade, the Central bank used a weekly auction for absorbing or injecting liquidity. From May 2008 to date, NBR replaced weekly auction and deposit facility (overnight) by repos operations.

· Open market operations

The Central bank accepts surplus liquidity from banks and in return transfers eligible securities to them as collateral. The two parties agree to reverse the transaction at a future point in time, when the Central bank as borrower repays the principal of the loan plus interest and the creditor bank returns the collateral to the Central bank.

The duration of these operations can vary between 1 to 14 days. Repos with shorter maturities are executed from time to time depending on the forecasts of banking sector liquidity.

Owing to the systemic liquidity surplus in the Rwanda banking sector, repo tenders are currently used exclusively for absorbing liquidity.

The bids are ranked using the Duch auction procedure.

Those with the lowest interest rate are satisfied as having priority and those with successively higher rates are accepted until the total predicted liquidity surplus for the day is exhausted.

If the volume ordered by the banks exceeds the predicted surplus, the Central bank either completely refuses the bids at the highest rate or reduces them pro rata.

Repo tenders are usually announced on Friday after the Monetary Policy Committee`s meeting and on another working day banks can bid for 1-day repo at around 2:00 PM. Banks may submit their orders for example the amounts of money and the interest rates at which they want to enter into transactions with the Central bank- within a prescribed time.

The minimum acceptable volume is RWF 50 million. Bids exceeding the minimum must be expressed as multiples of RWF 50 million.

· Reserve requirement

Cash reserve requirement can affect bank's free reserve in short run and supply of broad money. The cash reserve is one of the instruments available to NBR for controlling base money.

In an attempt to exert control over the money supply progress, the NBR introduced reserve requirements in August 1990. By compelling commercial banks to keep unused a certain fraction of customers' deposits, the central bank sought to sterilize a part of banks' resources usually used in extending credit. Indeed, keeping the required reserves on deposits at the NBR restricted credit expansion and consequently monetary growth rates. This was not part of any structural adjustment program, but may have been in anticipation of such changes.

· Discount window facility

Central banks usually limit access to their funds by commercial banks, by using a penalty rate and /or through the prescribed amount.

Motivated by a concern to supervise more closely monetary growth, the central bank made any credit extension by a commercial bank to its customers exceeding a certain amount subject to central bank authorization. Further, this authorization could not be interpreted as a right to increase the NBR's allocation at the discount window. This element of control made it possible to keep money supply growth within the constraints imposed by economic growth and keeping in mind that certain sectors of the economy were to be offered some priority status. In addition, credit control was likely to involve the central bank in the evaluation of the risk incurred by the banks concerned, and thus lead them to change their behavior and take into account the riskiness of their customers before making a loan. However, having said this, some activities, especially in agriculture did receive special support.

· Foreign exchange operations

The supplementary monetary instrument is foreign exchange operations (sales) mainly to smooth unexpected liquidity fluctuations in the market.

Treasury bills and Treasury Bonds market dominate the money market in Rwanda. Treasury bills can be mobilized for government financing or for monetary purposes for absorbing excess liquidity for long duration. (National Bank of Rwanda, Implementation of monetary policy 2010.)

In 2010, the BNR monetary policy will be conducted in a good international and national environment compared to last year. According to the IMF estimates, the world economic activity would recover by 3.1% in 2010 against a decrease of 1.1% on average in 2009 and come back to the normal trend as the global real GDP has increased by 3% and 5.2% in 2008 and 2007 respectively. This recovery in the world economic activities will have a positive impact on Rwandan external sector as well as the private transfers to Rwanda.

As mentioned earlier, the banking liquidity conditions and the capacity of banks to give loans to private sector have recovered to normal levels since mid-2009 and lending activity has been increasing since the third quarter of 2009. In addition, Rwanda expects an important budget support estimated at USD 5 19.03 million in 2010 against USD 409.63 million in 2009, which is an increase of 26.7%.

Based on these developments and expectations, the credit to private sector is expected to increase by at least 20%, coming back to the high growth rates observed before 2009. Indeed, annual growth of the credit to private sector between 2005 and 2008 was 29% on average and fluctuated between 26.1% and 36.3%. With this estimated level of credit to private sector, real GDP growth could be expected in the range of 7 - 8%, as observed in average during the period 2004-2008. (NBR. Monetary policy and financial stability statement, Feb 2010 p.29)

2.2.4 Money supply

In such context, monetary expansion exceeded markedly the level initially anticipated, the financial year under review having been marked by an over expansion of money supply estimated at 16.1% against real GDP growth of 3.4%.

Owing to the very high domestic financing of budget deficit, the growth of money supply exceeded the target of 9.2% anticipated in the monetary program for the year.

Figure 3: Development of money supply (in billions of RWF)

Source: NBR, Research department

During the year, money supply recorded a saw tooth development during the first half of the year, and a strong and continuous growth during the second half. By end of May 2003, money supply stood at RWF 150.5 billion, an increase of 4.5% compared to the situation at the end of December 2002. The development observed during the first half of the year was in keeping with the growth of 9.2% targeted for the whole year.

During the second half of the year, however, money supply recorded a fast and sustained evolution.

This development was a result mainly of the Government resorting to increased financing by the banking sector due to increased expenditure necessitated by the political timetable and irregular external financing ( NBR, Annual report,2003, p.47).

2.2.5 Exchange rate

Concerning the exchange rate policy for 2010, the priority of the National Bank of Rwanda remains to maintain a stable and predictable exchange rate of the RWF, and ensure that it remains fundamentally market driven.

BNR will continue to intervene on the market by selling and buying foreign exchange to banks to smoothen the RWF exchange rate volatility depending on the market demand and the volume of official foreign exchange reserves available.

Thus, in case there is an unexpected balance of payments pressures, it will require policy flexibility to maintain macro-economic stability and adjust to shocks.

More specifically, flexible exchange rate policy and proactive monetary policy will be reinforced, in order to avoid possible strong external shocks from higher imports or declining foreign exchange inflows which could lead to excessive reserve losses.

However, as previously, the BNR's interventions on foreign exchange market should be in line with its monetary policy objective of low inflation. Indeed, the Central bank sales and purchases to or from commercial banks will be maintained among important tools to be used in 2010 to regulate the banking system liquidity.

Regarding the Forex market infrastructure development, the BNR will continue the process of modernization of operations, by introducing a communication platform such as Reuters and other market technologies to enhance the market-determined Foreign exchange system (NBR, Monetary policy and financial stability statement, February 2010, p.30).

2.2.6 Interest rate

With the consolidation of comfortable short term liquidity in the banking system since the second half of 2009, money market interest rates have been recording a declining trend. The average Repo rates fell from 7.3% in January to 4.4% in December 2009. Regarding the commercial banks rates, banks become aggressive in deposits collection and increased deposit interest rates, between January and December 2009, from a monthly weighted average of 5.5% to 8.54%, after reaching a high level of 9.94% in July. Lending rates have been also increasing since January 2009 to reach 17.4% on average, before declining to 15.77% in December 2009.

This upward trend in lending rates in 2009 is linked to the uncertainties in credit markets, on both demand and supply sides, as the nonperforming portfolio has increased. As inflation rate in Rwanda has been significantly declining in 2009, banks real lending and deposit rates remained positives (NBR, Annual report 2009, p.48.)

CHAPTER 3: RESEARCH METHODOLOGY

3.1 Introduction

This chapter explains in few words how the research has been conducted. It gives the plan and strategy research design that is required for the study. The plan includes what is done from writing the hypotheses and their operational implications to the final analysis of data. The strategy includes the methods to be used to gather and analyze the data and implies how the research objectives was reached and how the problems encountered will be tacked (Kerlinger, 1973: 300)

The study covers the period of 1985-2010. It includes explanatory variables that explain the monetary policy. The CPI has been used as the dependent variable in the estimation. In this chapter the theory building is done for making the economic model and also the econometric technique is discussed for estimation of the model. The study setting and variable selection is also discussed and the data are taken from NBR Library and on the website of World Bank.

3.2 Model Specification

To investigate the impact of monetary policy on Consumer price index (CPI), this study builds on the literature review and theoretical framework in the previous chapters. By taking into consideration the above theories of economic growth, the model can be built as the follows:


Where

CPI: Consumer Price Index

M2: Money Supply

NIR: Nominal interest rate

EXCH: Exchange rate

Ut: Error term

In the model represented by equation above, are the parameters to be estimated and is the error term that captures other variables not explicitly included in the model. In addition, it is expected that < 0, , â3<0.

Modifying the classical quantity theory of money the Keynesian believe that money supply through its transmission mechanism affects the CPI indirectly. Monetarists while agreeing to Keynes that in the short run economy does not operate at full employment therefore expansionary monetary policy may work positively in the long-run they support classists that rising money supply will increase inflation only. Therefore they suggest that the policy must accommodate increase in CPI without changing price level (Lan lord, 2008).

Most of the modern economists are of the view that long run growth depends upon enhancement of productivity. If an appropriate monetary policy is supplemented by the external environment of suitable liquidity, interest rate, robust demand, soft assistance from the world bank of the financial institutions and debt rescheduling would lead to sustainable economic growth in the long run. (Laurence H. Meyer, 2001) (Russell, 2010) (Economy watch, 2010).

Price stability is a situation where inflation is low enough that it no longer has a material effect on people's economic decisions. A credible commitment by the monetary authorities to keeping inflation low and stable provides a climate conducive to sound economic decisions. It also leads to lower interest rates, supporting productive investments that allow the economy to grow at a sustainable, non-inflationary pace over time and to generate higher incomes and new jobs.

In that sense we see price stability as a measure of economical stability. In an economy where prices are considered stable, factors such as inflation and deflation have a minimal effect, and prices on goods and services change little from year to year. Generally, price stability is considered to be a good, though not necessarily totally achievable goal for an economy ( http://en.wikipedia.org/wiki/Inflation_targeting).

3.3 Research Design

The study was a qualitative and quantitative case design. Denzin and Lincoln (1994) define qualitative method as method that involves collecting information about personal experience, introspection, life story, interviews, observations, historical, interactions and visual text which are significant moments and meaningful in peoples' lives. The qualitative method investigates the why and how of decision making.

Quantitative Method refers to the systematic empirical investigation of social phenomena via statistical, mathematical or computational techniques. In quantitative research we are more interested in testing the hypothesis.

3.3.1 Quantitative and Statistics methods

Quantitative and Statistics method is used in analysis and presentation of data. In this study, data analysis and presentation are conducted using tables, graphs and figures.

3.4 Estimation techniques

This study employs the ADF and Johansen as a test of stationality, cointegration test and modeling. They are all adopted in order to arrive at a conclusion that will be free from any doubt and this can lead to the acceptance of conclusions and recommendations of the present research.

3.4.1 Unit Root Test

Consider the model:

The Stationarity condition is |ö| < 1. In general we have three possible cases.

|ö| < 1 and therefore the series are stationary.

|ö| > 1where in this case the series explodes.

ö = 1 where in this case the series contains a unit root and is non-stationary.

For testing that is there any unit roots in the series the Augmented Dickey-Fuller test for unit roots will be used.

The Augmented Dickey Fuller (ADF) test will be employed as a prior diagnostic test before the estimation of the model to examine the stochastic time series process properties of monetary policy and Consumer price index. This enables us to avoid the problems of spurious result that are associated with non-stationary time series models.

3.4.2 Co-integration Test

This is employed to determine the number of co-integrating vectors methodology with two different test statistics namely the Trace test statistic and the Maximum Eigen-value test statistic.

3.5 Data Collection Methods and Tool

In this research the impact of monetary policy on consumer price index (CPI), secondary data has been used. Secondary data are collected from NBR library and on the World Bank Website. In which there four variables such as: CPI, Money supply, Nominal Interest Rate and Exchange rate.

3.6 Sample Size

The study period consist of 25 years, from (1985-2010).

3.7 Statistical Test

In this research, software used to analyze data is Eviews7.

3.8 Characteristics of variables

3.8.1 Dependent variable

ü Consumer Price Index (CPI)

The Consumer Price Index (CPI) is a measure of changes in prices of goods and services within the household basket. In Rwanda the CPI is a Modified Laspeyres index that currently measures changes in prices of 1,136 goods and services in five provinces in Rwanda.

CPIs triple role:

Economic: The CPI permits monthly inflation monitoring. It is equally used as a deflator for a number of economic aggregates (consumption, revenues...) for measuring evolution in real terms (at constant prices).

Social-economic: In this case the monthly published CPI is also used in adjusting a number of public and private agreements like minimum wages, pensions, social benefits to mention a few Monetary.

Financial: The CPI is as well used extensively in monetary policy and in regional and international price comparison purposes.

Production and Publication: The CPI in Rwanda is published monthly by the National Institute of Statistics of Rwanda that works in collaboration with the National Bank of Rwanda on the 15th of the preceding month. In constructing the index, the consumption nomenclature adopted is derived directly from the international nomenclature COICOP (Classification of individual consumption by purpose; SNA revision IV 1993) ( http://www.statistics.gov.rw/indicator/consumer-price-index).

It consists of 12 divisions that are further divided into groups, classes, categories and products and services.

The 12 categories include:

· Food and non-alcoholic beverages

· Alcoholic beverages and Tobacco

· Clothing and footwear

· Housing, water, electricity, gas and other fuels

· Furnishing, household equipment and routine household maintenance

· Health

· Transport

· Communication

· Recreation and culture

· Education

· Restaurants and hotels

· Miscellaneous goods and services

3.8.2 Independent variables

ü Money Supply (M2)

Money supply is the total amount of money available in an economy at a particular point of time. The importance of an appropriate monetary aggregate can hardly be over emphasized, particularly for those countries that attach their monetary policy to monetary aggregates. The breakdown of stable relationship between monetary aggregates and macroeconomic variables due to structural change in financial markets and emergence of new financial instruments led to frequent changes in the definition of monetary aggregates. In practice more than one monetary aggregate are usually defined in the hope that multiple aggregates may collectively provide more information for the conduct of monetary policy and developments in the economy.

ü Interest Rate

The term interest rate usually means any bank lending rate. However, the rates don't always move rapidly because they are driven by different forces. On treasury notes, like any loan, the interest rates are fixed. However, Treasury notes are auctioned to the highest bidder. Depending on the demand at auction, the note could cost more or less than face value. However, at the end of the note's term, the Government pays back full face value to the bidder. In effect, bidders are loaning the bid amount to the Government. In return, they get the interest rate and the full face value.

ü Exchange rate

Exchange rate regime considerations play a strong role in influencing monetary policy in a country. The rate of exchange means the price of one currency in comparison with another currency.

Mishkin (1997) argued that «if a Central Bank does not want to see it currency fall in value, it may pursue a more contractionary monetary policy and reduce the money supply to raise the domestic interest rate, thereby strengthening its currency.


3.9 Data processing

The aim of data collection was to analyze and interpret those data in order to achieve the conclusion that will be applied in the context of improving organization. The data analyzed concern CPI, Money supply (M2), Exchange rate; Nominal Interest rate, the analysis has been done using econometric analysis. The result of analysis done was clearly presented in next chapter and the conclusions and recommendations based on this analysis were given in last chapter.

3.10 Limitations & Delimitations

I cannot explain the overall impact of monetary policy because it is difficult to cover all variables and their impact on Consumer Price Index (CPI) because of shortage of time. Monetary policy affects the economy and decrease in unemployment, poverty, and increase in investment, savings, foreign investment, price stability and time lag of monetary policy.

CHAPTER 4: RESEARCH FINDINGS

Introduction

This chapter presents the findings from the research carried out on impact of monetary policy on Consumer Price Index (CPI) from 1985 to 2012. The researcher attempted to analyze the data in order to answer to the research questions set at the beginning of this study.

This chapter has two parts: strategies of monetary policy in stabilizing economy and impact of monetary policy on Consumer Price Index (CPI).

4.1 Strategies of monetary policy in stabilizing economy

The National Bank of Rwanda uses different tools of monetary policy in order to stabilize economy. It uses them in attempting to achieve the objectives of the monetary policy. With those tools, money supply, credit, interest rates and other monetary variables can be manipulated by the Central bank of Rwanda in order to achieve predetermined policy goals.

4.1.1 Open market operations

This refers to purchase and sales of government securities in the money market. When the Central bank wants to reduce money supply or credit availability, it sells the securities to the public. On the other hand, if the Central bank wants to increase money supply and credit availability, it buys securities from the public. This avails money to the public for economic activities. In so doing, the Central bank controls inflationary and deflationary pressures (Assiimwe H. M., 2009:192).

In Rwanda, the Central bank accepts surplus liquidity from banks and in return it transfers eligible securities to them as collateral. The two parties agree to reverse the transaction at a future point in time, when the Central bank as borrower repays the principal of the loan plus interest and the creditor bank returns the collateral to the Central bank. The duration of these operations can vary between 1 to 14 days. Repos with shorter maturities are executed from time to time depending on the forecasts of banking sector liquidity. Owing to the systemic liquidity surplus in the Rwanda banking sector, repo tenders are currently used exclusively for absorbing liquidity (implementation of monetary policy by National Bank of Rwanda 2010).

The bids are ranked using the Duch auction procedure. Those with the lowest interest rate are satisfied as having priority and those with successively higher rates are accepted until the total predicted liquidity surplus for the day is exhausted.

If the volume ordered by the banks exceeds the predicted surplus, the Central bank either completely refuses the bids at the highest rate or reduces them pro rata.

Repo tenders are usually announced on Friday after the Monetary Policy Committee`s meeting and on another working day banks can bid for 1-day repo at around 2:00 PM. Banks may submit their orders the amounts of money and the interest rates at which they want to enter into transactions with the Central bank- within a prescribed time. The minimum acceptable volume is RWF 50 million. Bids exceeding the minimum must be expressed as multiples of RWF 50 million (implementation of monetary policy by National Bank of Rwanda2010).

4.1.2 Reserve requirement

Commercial banks must maintain a given fraction of deposits with the Central bank. These reserves are mandatory and so, are called legal reserve requirements. These reserves are stated as percentage of the deposits. The Central bank can manipulate this reserved requirement to influence money available to commercial banks and the public.

When the Central bank wants the money supply reduced, it increases the reserves required and by reducing it, it increases money supply (Assiimwe H. M.,2009:192).The cash reserve is one of the instruments available to NBR for controlling base money(implementation of monetary policy by National Bank of Rwanda2010).

4.1.3 Discount rate

One of the functions of the Central bank is to act as a lender of last resort, that is, when commercial banks are in dire need of cash, they can borrow from the Central bank and the Central bank extends credit to the commercial banks at an interest rate called bank rate (discount rate).

This rate has a direct relationship with the interest rate that the banks charge their borrowers. When the commercial banks are charged a higher bank rate, they likewise charge a higher interest rate to the borrowers. Whenever, the Central bank wants a reduction in money supply, it raises the bank rate. This forces the commercial banks to raise the interest rate which in turn discourages borrowing (Assiimwe H. M., 2009:192).

4.1.4 Exchange Rate

The balance of payments can be in deficit or in surplus and each of these affect the monetary base, and hence the money supply in one direction or the other. By selling or buying foreign exchange, the Central bank ensures that the exchange rate is at levels that do not affect domestic money supply in undesired direction (macroeconomics course).

4.1.5 Direct Credit Control

The Central bank can direct Deposit Money Banks on the maximum percentage or amount of loans (credit ceilings) to different economic sectors or activities, interest rate caps, liquid asset ratio and issue credit guarantee to preferred loans. In this way the available savings is allocated and investment directed in particular directions (Macroeconomics course)

4.1.6 Moral Suasion

The Central bank issues licenses or operating permit to Deposit Money Banks and also regulates the operation of the banking system. It can, from this advantage, persuade banks to follow certain paths such as credit restraint or expansion, increased savings mobilization and promotion of exports through financial support, which otherwise they may not do, on the basis of their risk/return assessment (Macroeconomics course).

4.2 Impact of monetary policy on Consumer Price Index (CPI)

In this study, we have used variables like Money supply, Nominal interest rate and the nominal exchange rate in order to measure the impact of monetary policy on Consumer Price Index (CPI). The monetary policy affects an economy by causing inflation which discourages production in the country. But before that, it is better to analyze the evolution of those variables in Rwanda such as: Consumer Price Index, Money supply, Nominal interest rate and the nominal exchange rate.

4.2.1 Evolution of CPI, money supply, Nominal interest rate and nominal exchange rate in Rwanda

This part of the study analyzes trends of different variables that are used in the following part of the study:

Table 1: Consumer price index (CPI) in Rwanda

 
 

1985

11.00181

1986

10.87891

1987

11.32854

1988

11.66598

1989

11.78383

1990

12.27708

1991

14.68795

1992

16.09218

1993

18.08027

1994

35.96796

1995

38.63368

1996

43.27568

1997

45.96313

1998

44.85729

1999

46.60651

2000

48.1645

2001

49.12422

2002

52.78382

2003

59.25022

2004

64.59108

2005

70.3286

2006

76.71494

2007

88.56351

2008

97.74297

2009

100

2010

105.6707

Figure 4: Consumer Price Index (CPI) in Rwanda

Source: Eviews7

As it can be seen, from 1985 to 2010, the CPI of Rwanda was generally increasing. This increase in is due to different causes which may be internal and external. The continual increase in prices discourages production of a given country. Normally, other things being equal, increases in domestic price discourage production while decreases in price encourage production.

Table 2: Money Supply in Rwanda

 

M2

1985

2.33E+10

1986

2.65E+10

1987

2.92E+10

1988

3.14E+10

1989

3.01E+10

1990

3.17E+10

1991

3.35E+10

1992

3.77E+10

1993

3.86E+10

1994

3.72E+10

1995

6.3E+10

1996

6.85E+10

1997

8.84E+10

1998

9.15E+10

1999

9.87E+10

2000

1.14E+11

2001

1.27E+11

2002

1.43E+11

2003

1.65E+11

2004

2.15E+11

2005

2.53E+11

2006

320972.6

2007

425211.5

2008

466146.4

2009

491194.6

2010

617709.7

Figure 5: Money Supply in Rwanda

Source: Eviews7

As it can be seen from the figure above, from 1985 up to 2005, the money supply was increasing but not significantly, but it decreased considerably in 2006, however, from that year, the money supply started increasing again. Normally, as it is known that, much money in circulation is most of the time associated with inflation but also; little money in circulation can be associated with problem. The central bank of Rwanda must have strong reasons of reducing money in such a way, may be because of inflation which was increasing significantly as seen in figure above.

Table 3: Nominal Interest Rate in Rwanda

 

NIR

1985

13.875

1986

14

1987

13

1988

12

1989

12

1990

13.16667

1991

19

1992

16.66667

1993

15

1994

16.77

1995

16.77

1996

18.54

1997

16.22

1998

17.13

1999

16.84

2000

16.99

2001

17.29

2002

16.37

2003

17.05

2004

16.48

2005

16.08

2006

16.07

2007

16.11

2008

16.51

2009

16.09

2010

16.67

Figure 6: Nominal Interest Rate in Rwanda

Source: Eviews7

From 1986 to 1989, the Nominal interest rate was decreasing. From 1989 up to 1991, it was increasing but it decreased gradually until 1993.

From 1995, the nominal interest rate was also increasing until 1996 and after that year, the interest rate in Rwanda almost stabilized in many years.

Normally, the high nominal interest rate is a sign of refusal by commercial banks to offer credits to borrower, most of the time, that results from the discount rate charged by the central bank to commercial banks. That desire is always associated by a desire of the central bank to reduce money in circulation and stabilize economy in order to avoid inflation. The low nominal interest rate is a sign that commercial banks are giving loans to those who need them and event is associated by the central bank which reduces the discount rate charged to commercial banks in order to increase money in circulation with a desire of stimulating production.

Table 4: Nominal Exchange Rate in Rwanda

 

EXCH

1985

101.2447

1986

87.59092

1987

79.46065

1988

76.44774

1989

80.14898

1990

83.7041

1991

125.1642

1992

133.9386

1993

144.237

1994

140.7038

1995

262.1823

1996

306.82

1997

301.5298

1998

312.3141

1999

333.9419

2000

389.6962

2001

442.9919

2002

475.3652

2003

537.655

2004

577.449

2005

557.8226

2006

551.7103

2007

546.955

2008

546.8487

2009

568.2813

2010

583.1309

Figure 7: Nominal Exchange Rate in Rwanda

Source: Eviews7

From 1985, the Rwandan currency was being appreciated, but from 1988, it started depreciating in general and it became almost stable from 2005 up to 2007. From 2008, the Rwandan currency was generally depreciating.

4.2.2 Econometric analysis of the impact of monetary policy on Consumer Price Index

In this part of the study, we use econometric tools in order to analyze the impact of monetary policy on Consumer Price Index. The money supply M2, the nominal interest rate and the nominal exchange rate are used as independent variables in order to measure their impact on CPI. Then, we want to check whether the monetary policy causes inflation or not.

4.2.2.1 Analysis of stationarity for different variables

In order to arrive at good conclusions and propose important policies, data to be used must be stationary or made stationary .Non-stationary variables can lead to misleading inferences. So, the following is the analysis of stationarity by using the PP and ADF tests.

Table 5: Summary of Unity root Test using PP and ADF tests

Variables

PP test

ADF test

Conclusion

 

Level

Intercept & Trend

Intercept

None

Intercept & Trend

Intercept

None

I(1)

LCPI

Level

-1.509203

-0.037775

1.304367

-1.593095

-0.166940

1.201365

?level

-5.671982*

-5.278210*

-5.107284*

-5.541824*

-5.277734*

-5.107284*

LM2

Level

-1.808800

-0.840839

-0.919552

-1.808800

-0.840839

-0.912034

I(1)

?level

-5.215006*

-5.172020*

-5.156853*

-5.206502*

-5.171833*

-5.156853*

LEXCH

Level

-1.465468

-0.700263

 2.044835

-1.295550

-0.700263

 2.189489

I(1)

? level

-4.560735*

-4.493495*

-3.732926*

-3.798612**

-4.506769*

-3.755935*

LLIR

Level

-2.598714

-2.192332

0.665482

-2.238489

-2.087310

0.279109

I(1)

? level

-6.873350*

-6.320553*

-6.143093*

-4.021954**

-2.074770

-1.859478***

Source: Eviews7

* Indicates statistical significant at the 1 percent level,

** Indicates statistical significant at the 5 percent level

*** Indicates statistical significant at the 10 percent level.

From the table above, it can be deduced that variables are not stationary at level. We did not found statistical evidence of rejecting the Null hypothesis of unit root because the asymptotic critical values are less than the calculated value for ADF and the p values are more than 5%. However, when all the variables are transformed to their first difference, the null hypothesis is rejected and variables became stationary. Finally, we concluded that all variables are integrated of order one.

4.2.2.2 Co-integration test

If two or more time series are not stationary, it is important to test whether there is a linear combination of them which is stationary. This phenomenon is referred to as the test for co-integration. The evidence of co-integration implies that there is a long run relationship among the variables. Hence, the short-run dynamics can be represented by an error correction mechanism (Engle and Granger, 1987).

There are two most popular approaches for testing for cointegration, the Engle- Granger two steps procedure and the Johansen procedure. In this research, we applied the Johansen Maximum Likelihood Methodology for the cointegration test. The obtained results are in the following table:

Table 6: Results of Johansen Cointegration Test

Unrestricted Cointegration Rank Test (Trace)

 
 
 
 
 
 
 
 
 
 
 

Hypothesized

 

Trace

0.05

 

No. of CE(s)

Eigenvalue

Statistic

Critical Value

Prob.**

 
 
 
 
 
 
 
 
 
 

None

 0.650795

 45.29174

 54.07904

 0.2391

At most 1

 0.340354

 20.04146

 35.19275

 0.7242

At most 2

 0.221537

 10.05623

 20.26184

 0.6343

At most 3

 0.155133

 4.045828

 9.164546

 0.4053

 
 
 
 
 
 
 
 
 
 

 Trace test indicates no cointegration at the 0.05 level

 * denotes rejection of the hypothesis at the 0.05 level

 **MacKinnon-Haug-Michelis (1999) p-values

 

Unrestricted Cointegration Rank Test (Maximum Eigenvalue)

 
 
 
 
 
 
 
 
 
 

Hypothesized

 

Max-Eigen

0.05

 

No. of CE(s)

Eigenvalue

Statistic

Critical Value

Prob.**

 
 
 
 
 
 
 
 
 
 

None

 0.650795

 25.25028

 28.58808

 0.1260

At most 1

 0.340354

 9.985229

 22.29962

 0.8363

At most 2

 0.221537

 6.010404

 15.89210

 0.7868

At most 3

 0.155133

 4.045828

 9.164546

 0.4053

 
 
 
 
 
 
 
 
 
 

 Source: Eviews7

Max-eigenvalue test indicates no cointegration at the 0.05 level

 * denotes rejection of the hypothesis at the 0.05 level

 **MacKinnon-Haug-Michelis (1999) p-values

 

The Trace test as well as the Maximum Eigenvalue test reveals that variables are not co-integrated. Then, these variables are not co integrated to run a regression line by using OLS. Such a regression can lead to misleading inferences. So, we have to use other methods such as unrestricted VAR.

4.2.2.2.1 Estimation of an impact of monetary policy on CPI of Rwanda

The coefficients of our model are numerous and not readily subject to interpretation. Hence, the interpretation follows from the path of the impulse response functions generated from the recursively-orthogonalized VAR estimated residuals. The impulse responses show the path of CPI when there is an increase in the monetary policy variables.

Figure 8: Response of CPI to Monetary Policy Variables

The figure 8 shows three panels of impulse response graphs indicating how increase in respective monetary policy variables affects the CPI of Rwanda in a period of five years. Each panel illustrates the response of CPI to a one standard deviation innovation (corresponding to an increase) in the monetary policy variable.

A value of zero means that the increase in monetary policy variable has no effect on CPI of Rwanda and the CPI continues to behave as if there was no increase in monetary policy variable. A positive or negative value indicates that the increase in the monetary policy variable would cause the CPI of Rwanda to be above or below its natural path as the case may be. The blue lines depict the estimated effects, while the dashed red lines show the boundaries of a 95% confidence interval.

In Panel 1, we observe that an increase in nominal exchange rate has an effect of increasing quickly inflation in the first year, and in the second year it becomes stationary while it increases again in the third year and becomes stationary in the following years. In general, the increase in nominal exchange rate has an effect of increasing the inflation in Rwanda as the blue line is above the natural path. This increase of inflation resulting from the depreciation of Rwandan currency is as expected by theories and given the structure of Rwandan economy. Normally, when there is a depreciation of a country's currency, the theory predicts that the country's exports become cheap while its imports become expensive.

Panel 2 shows how the CPI of Rwanda responds to an increase of nominal interest rate. Increase of nominal interest rate in Rwanda has an effect of decreasing inflation in the first two years. However, in the third year, inflation increases again and reaches its level of beginning in the fourth and fifth year. In the following years, inflation is found to decrease. This is logical because increase in nominal interest rate discourages people to ask for loans and consequently reduces money into circulation.

Panel 3 shows the response of CPI to a positive shock in money supply measured by M2. When there is an increase in money supply in Rwanda, inflation decreases considerably in the first year. However, in the second year, inflation start increasing again and it reaches its original level in the seventh but it increases again in the tenth year. It means that, when monetary authorities realize a need of stimulating production, they increase money into circulation. That increased money is invested into productive activities which increase production in Rwanda.

That increase in production results in reduction of prices in the first year. However, it has been seen that the continual increase of money supply push again prices up in the following years and prices reaches its original level in the seventh year.

CHAPTER FIVE: SUMMARY, CONCLUSION AND RECOMMENDATIONS

Introduction

This chapter presents the summary of the study and it provides conclusions and recommendations.

5.1 Summary

The research study on the impact of monetary policy on Consumer price index was conducted by taking NBR as a case study. Our main purpose was to evaluate the use of monetary policy and the specific objectives were to describe strategies of monetary policy in stabilizing economy and to determine the impact of monetary policy on Consumer price index (CPI).

To achieve the desired objectives, the researcher consulted different documents on monetary policy and collected Secondary data on different time series where they obtained data were tested for stationarity in order to avoid regression involving non-stationary variables which can lead to misleading inferences. ADF and PP tests were used to check for stationarity. Engle- Granger two steps procedure and the Johansen Maximum Likelihood Methodology were used to see whether variables are co integrated or not. All those two tests revealed that there is no cointegration among our variables. And this has leaded us to the use of impulse response in order to estimate the impacts of monetary policy on Consumer price index (CPI).

The research found that the National Bank of Rwanda uses different tools of monetary policy in order to stabilize economy. It uses them in attempting to achieve the objectives of the monetary policy. With those tools, money supply, credit, interest rates and other monetary variables can be manipulated by the central bank of Rwanda in order to stabilize Rwandan economy. When the central bank wants to reduce money supply or credit availability, it sells the securities to the public. On the other hand if the central bank wants to increase money supply and credit availability, it buys securities from the public. The central bank can manipulate the reserve requirements in order to influence money available to commercial banks and the public.

When the central bank wants the money supply reduced, it increases the reserves required and by reducing it, it increases money supply.

The central bank can achieve its objective by charging high or low discount rate to commercial banks depending on its desire. Whenever, the central bank wants a reduction in money supply, it raises the bank rate and vice versa. By selling or buying foreign exchange, the Central Bank ensures that the exchange rate is at levels that do not affect domestic money supply in undesired direction.

With a direct credit control, the available savings can be allocated and investment can be directed in particular directions. And the central bank can persuade commercial banks to follow certain paths such as credit restraint or expansion, increased savings mobilization and promotion of exports through financial support, which otherwise they may not do, on the basis of their risk/return assessment.

By using tools of econometrics, the research founds that the monetary policy can affect the Consumer price index (CPI) and the following have been found:

ü The nominal exchange rate has been increasing during the period under consideration .And an increase in nominal exchange rate of Rwanda has an effect of increasing quickly inflation in the first year, and in the second year it becomes stationary while it increases again in the third year and becomes stationary in the following years. In general, the increase in nominal exchange rate has an effect of increasing the inflation in Rwanda as the blue line is above the natural path.

ü The nominal interest rate has also been increasing .Increase of nominal interest rate in Rwanda has an effect of decreasing inflation in the first two years. However, in the third year, inflation increases again and reaches its level of beginning in the fourth and fifth year. In the following years, inflation is found to decrease.

ü Money supply has been found to increase during the period under consideration, but it decreased considerably in 2006, but from that year, the money supply started also to increase again. When there is an increase in money supply in Rwanda, inflation decreases considerably in the first year. However, in the second year, inflation start increasing again and it reaches its original level in the seventh but it increases again in the tenth year.

5.2 General conclusion

In order to evaluate the use of monetary policy, the researcher carried out a research with the following specific objectives: to determine the impact of monetary policy on Consumer price index (CPI).and to describe strategies of monetary policy in stabilizing economy.

In order to achieve those objectives, documentary research has been done on Strategies of monetary policy in stabilizing economy and tools of econometrics have been used in order to analyze the collected data and all that led to the following:

ü Open market operation , reserve requirements , discount rate, selling or buying foreign exchange, direct credit control and moral suasion are the different strategies that the central bank of Rwanda uses in monetary policy in order to stabilize economy. It uses them in attempting to achieve the objectives of the monetary policy. With those tools, money supply, credit, interest rates and other monetary variables can be manipulated by the central bank of Rwanda in order to achieve predetermined policy goals. This becomes possible because the central bank is the one which designs and implements monetary policy on behalf of the government. It has the duty of ensuring economic stability of a country. It is the one which is responsible for issuing money in accordance with the level of economic activities.

ü The Rwandan currency has been depreciating during the period under consideration. However, a depreciation of Rwandan currency has been found to increase inflation in Rwanda. This increase of inflation resulting from the depreciation of Rwandan currency is as expected by theories and given the structure of Consumer price index (CPI). Normally, when there is a depreciation of a country's currency, the theory predicts that the country's exports become cheap while its imports become expensive. That is why, for Rwanda, when the Rwandan currency gets depreciated, it becomes easy to export while it is difficult to import. Or, as we know the structure of Rwandan economy, Rwanda does not have more things to export and it is obliged to import some goods in order to survive.

That is why, when there a depreciation of Rwandan currency, Rwanda becomes obliged to import goods which became more expensive and this brings inflation in Rwanda.

ü The nominal interest rate has also been increasing. That increase in nominal interest rate can be explained by fact that the central bank of Rwanda has been increasing the bank rate charged to commercial banks. And when commercial banks are charged a higher interest rate, they likewise charge a higher interest rate to the borrowers. The central bank raised the bank rate may be by a desire of reducing the money supply in order to curb inflation.

This is logical because increase in nominal interest rate discourages people to ask for loans and consequently reduces money into circulation. So, when there is a problem of inflation in Rwanda, the monetary authorities may increase the nominal interest rate which has an effect of reducing money into circulation and decrease inflation in the country. However, that happens only in the first two years because in the following years, inflation increases and reaches its original level.

This increase in inflation resulting from the increase in nominal interest rate is due to the fact that a high interest rate can discourage investment which discourages production. So, the scarcity of production on local market pushes prices up and brings prices to increase.

ü Findings reveal that when there is an increase in money supply in Rwanda, inflation decreases considerably in the first year.

However, in the second year, inflation start increasing again and it reaches its original level in the seventh but it increases again in the tenth year. Also, money supply has been found to increase during the period under consideration, but it decreased considerably in 2006, but from that year, the money supply started also to increase again. That is why, when monetary authorities realize a need of stimulating production, they increase money into circulation.

That increased money is invested into productive activities which increase production in Rwanda. That increase in production results in reduction of prices in the first year. However, it has been seen that the continual increase of money supply push again prices up in the following years and prices reaches its original level in the seventh year.

5.3 Recommendations

ü The central bank should decrease the interest rate in order to motivate investors and increase the level of production in Rwanda. Those investors should however be motivated and oriented to invest strategic sectors in order to find solutions to a weak supply capacity of Rwanda in international trade by promoting export of Rwanda. This can reduce also the Rwandan imports and this can be a solution to inflation in Rwanda.

ü Monetary authorities should do their best in order to avoid the depreciation of

Rwandan currency because the depreciation of Rwandan currency brings nothing

except to bring inflation in Rwanda.

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